Mike Konczal has a new post criticizing the recent NYT piece by Beckworth and Ponnuru. He makes four points. The first is that Senator Cruz’s views on money are not always consistent. Even if true, that has no bearing on the Beckworth/Ponnuru argument. Here’s the second:

A lot depends on what we mean by “cause.” Google “define:cause” and I get “make (something, typically something bad) happen.” But the authors really mean “didn’t prevent” here. There is a fascinating Myth of Ownership/”you didn’t build that” element here – where is the line between the market and the state that structures it? But the story is simple: there was an aggregate demand shortfall from the housing collapse, and the government didn’t step in to fix it.

In that same exact way, the stimulus not being large enough also caused the Great Recession. Sure, but I doubt Ted Cruz would agree with that statement.

This is a completely meaningless distinction, when it comes to monetary policy. As Nick Rowe points out there is no meaningful distinction between the Fed acting and not acting. Monetary policy can be described along many dimensions, including interest rates, the base, M2, exchange rate, and NGDP expectations. Acting in one dimension might mean not acting in terms of another. And this isn’t even one of those “Keynesian vs. Monetarist” things where no one can say who’s right. Konczal’s fellow Keynesian Paul Krugman frequently describes Fed action/inaction in terms of changes in the base, whereas Konczal considers action in terms of changes in interest rates. The growth rate of the base slowed sharply in late 2007 and early 2008, so using Krugman’s criterion Fed “acted” to make policy tighter right before the recession. Under Konczal’s the Fed “acted” to make it easier. (Of course later the base soared, so by Krugman’s criterion money became much looser.)

In my view neither the base nor the level of interest rates are good indicators of what the Fed “is doing”, and I’m pretty sure that Beckworth and Ponnuru agree. We evaluate Fed policy in terms of changes in NGDP, or expected NGDP growth. By that criterion, policy got more contractionary. Konczal may not like this view, but it’s basically the view of Ben Bernanke before he became Fed chair, so no one can claim we are trying to come up with some whacky new way of describing the stance of monetary policy.

As for the housing “collapse”, it had almost no impact on unemployment. Housing construction plunged by more than 50% between January 2006 and April 2008, and unemployment merely edged up from 4.7% to 5.0%, so Konczal is flat out wrong in claiming that AD plunged due to a housing collapse. AD plunged due to a tight money policy from April 2008 to October 2009, which caused unemployment to soar from 5% to 10%. Jobs were lost in many industries, not just housing construction.

Konczal continues:

I think a lot of people’s frustrations with the article – see Barry Ritholtz at Bloomberg here – is the authors slipping between many possible interpretations. Here’s the three that I could read them making, though these aren’t actual quotes from the piece:

(a) “The Federal Reserve could have stopped the panic in the financial markets with more easing.”

There’s nothing in the Valukas bankruptcy report on Lehman, or any of the numerous other reports that have since come out, that leads me to believe Lehman wouldn’t have failed if the short-term interest rate was lowered.

I’m no expert on Lehman, but the financial crisis as a whole would have been far milder if the Fed had kept NGDP growing at roughly 5%/year. And the reason is simple; at that growth rate the asset markets would have been far stronger, and the crash in asset prices severely impacted the balance sheets of many banks, including Lehman. Keep in mind that the subprime crash was not big enough to bring down the banking system. Rather when NGDP growth expectations plunged, the prices of homes in the (non-bubble) heartland states, as well as commercial property, began falling. This is what turned a manageable financial crisis into a major crisis. But even with a major crisis, the Fed was quite capable of boosting NGDP sharply. They showed this in 1933, when NGDP rose strongly despite one of the most severe banking crises in American history, which shut down 1000s of banks for many months.

(b) “The Federal Reserve could have helped the recovery by acting earlier in 2008. Unemployment would have peaked at, say, 9.5 percent, instead of 10 percent.”

That would have been good! I would have been a fan of that outcome, and I’m willing to believe it.

Talk about damning with faint praise! If the Fed had kept NGDP growing at 5% then obviously unemployment would not have risen to 9.5%, a figure like 6% is more plausible. So is Konczal claiming that the Fed would have been unable to boost NGDP? Why? And why did they succeed in 1933? Devaluation? Then do the modern equivalent—level targeting.

Is the argument that we’d somehow avoid the zero-lower bound? Ben Bernanke recently showed that interest rates would have had to go to about -4 percent to offset the Great Recession at the time. Hitting the zero-lower bound earlier than later is good policy, but it’s still there.

There are lots of problems here. The Bernanke claim was that the Taylor rule implied a minus 4%, but that’s in 2009, not 2008. And that distinction really matters! The graph Konczal shows has the Taylor Rule suggesting an interest rate in positive territory in 2008. In any case, the Bernanke article Konczal links to is critical of the Taylor Rule, so it cannot possibly be used as evidence that Bernanke thought a negative 4% interest rate was appropriate in 2008, or even 2009. If he had thought that, why would the Fed have set rates at positive 2% in mid-2008? Sure, there are data lags but not 600 basis points worth of them. The fact of the matter is that the Fed didn’t cut rates more aggressively because at the time they thought it would lead to excessive inflation. It’s pretty hard to now claim that our wonderful economic models somehow show that even far lower interest rates could not possibly have prevented deflation and deep recession in 2009. If our models were that accurate we never would have had a Great Recession.

As an analogy, it would be like claiming that a small adjustment in steering by a bus driver could not possibly have prevented a bus from going over a cliff further on, because 100 yards further down the road even a big adjustment in steering would not have been enough.

A lot of the “expectations” stuff has a magic and tautological quality to it once it leaves the models and enters the policy discussion, but the idea that a random speech about inflation worries could have shifted the Taylor Rule 4 percent seems really off base. Why doesn’t it go haywire all the time, since people are always giving speeches?

I’m tempted to say that one needs to first understand “stuff” like rational expectations models, before dismissing them. Speeches only matter when they provide new information that causes markets to change their views as to the expected future path of monetary policy. Very few speeches do that.

And couldn’t it be just as likely that since the Fed was so confident about inflation in mid-2008 it boosted nominal income, by giving people a higher level of inflation expectations than they’d have otherwise? Given the failure of the Evans Rule and QE3 to stabilize inflation (or even prevent it from collapsing) in 2013, I imagine transporting them back to 2008 would haven’t fundamentally changed the game.

If your mental model is that the Federal Reserve delaying something three months is capable of throwing 8.7 million people out of work, you should probably want to have much more shovel-ready construction and automatic stabilizers, the second of which kicked in right away without delay, as part of your agenda. It seems odd to put all the eggs in this basket if you also believe that even the most minor of mistakes are capable of devastating the economy so greatly.

No, if these three-month errors are so consequential then you want to shift to a monetary regime where they are not so consequential, like NGDP level targeting. With that regime a three month miss would not cause asset prices to collapse.

I once made a graph showing that unemployment in the housing bust areas grew much faster than in the rest of the country from late 2006 right up until September 2008. The big exception (which provides evidence for the rule) is Las Vegas, where unemployment continued growing faster than in the rest of the country after September 2008.

Normally, I would think people would stick to characterizing policy in terms of things that are directly controlled by the institution in question, but you seem to think that objectives are equivalent to tools in monetary policy:

“Monetary policy can be described along many dimensions, including interest rates, the base, M2, exchange rate, and NGDP expectations. Acting in one dimension might mean not acting in terms of another.”

The monetary base and interest rates are natural indicators of monetary policy; central banks have the direct ability to set the monetary base or set interest rates (leaving MB demand determined). Strangely, you also have no problem adding “M2 … and NGDP expectations” — both things that no central bank has direct control over — to your list of monetary policy ‘tools.’ Additionally, you refer to exchange rates as a tool of policy instead of a goal of policy.

These three additions should never be simply assumed exogenous to the central bank; all three of them are variables that central banks can target, but not that they can use as policy tools. What you’re effectively arguing is that the stance of policy be evaluated by how potentially targeted variables evolve over time rather than how the tools do.

Essentially, this is like interpreting ‘inflation targeting’ to mean ‘inflation pegging’ and saying that any deviation of inflation from target is the direct fault of the central bank. You are doing what no respectable New Keynesian would ever do (regardless of the zero lower bound) — setting inflation exogenous in the model and seeing what happens.

There’s a reason NK models have Taylor Rules instead of just inflation pegs, but you evidently don’t care about this reason. Any nominal variable is apparently fair game, no matter how little control central banks directly wield over it.

Simply consider the quantitative difficulties: you are suggesting that the Federal Reserve should be able to anticipate and model money demand to such an extent that it knows what level of monetary base will be consistent with on-target NGDP. This is utterly impractical, and anyone should be able to see that.

To you, and I guess also Beckworth, there is no difference between monetary policy tools and objectives. This is about what can reasonably be considered exogenous and both of you consistently push the limits — if not completely destroy them — in this regard; you prescribe some kind of omniscience to central banks so that they somehow know at all times how to peg variables onto target and then blame central bankers for not exercising this omniscience.

“So is Konczal claiming that the Fed would have been unable to boost NGDP? Why?”

Just because you’ve gotten the idea into your head that central banks can always control NGDP, doesn’t mean anyone else does (or should). Keynesians will keep making the same argument as Konczal, so you may as well actually bother to explain how you think liquidity traps don’t exist instead of playing dumb and pretending that everyone who doesn’t agree with you about central bank omnipotence has their head in the clouds. Heck, I’ve literally outlined two specific versions of a liquidity trap in comments on your blog and you didn’t bother to deal with either model specifically. Fine, assert that the zero lower bound is not an issue, but as long as you don’t actually address the criticisms that people make, don’t expect them to buy into your ideology.

In a nutshell: please, for the love of sanity, stop assuming NGDP is exogenous and actually explain why you don’t believe in liquidity traps using models more complicated than M*V(i) = PY.

I see John Hanley picked up on the very passage* in Sumner’s post I was going to quote, and indeed he amplifies it.

My question to Sumner: given the broad nature of the passage below, do you concede that it includes the concept that money may be largely neutral in the short term?

* Sumner: “This is a completely meaningless distinction, when it comes to monetary policy. As Nick Rowe points out there is no meaningful distinction between the Fed acting and not acting. Monetary policy can be described along many dimensions, including interest rates, the base, M2, exchange rate, and NGDP expectations.”

“Simply consider the quantitative difficulties: you are suggesting that the Federal Reserve should be able to anticipate and model money demand to such an extent that it knows what level of monetary base will be consistent with on-target NGDP. This is utterly impractical, and anyone should be able to see that.”

– Have you ever heard of the prediction market? Or targeting the forecast?

@John Hanley_ you’re right as rain but Sumner will never concede his snake oil NGDPLT, as he’s based his professional reputation on it. He will claim central banks do set expectations via “open mouth (jawboning) operations”, and cite the Plaza Accords of the 1980s as evidence central banks can set exchange rates. As an aside, by Sumner’s own admission, he had his “Damascus conversion” in 2008, and started badgering colleagues about Fed inaction. Try to imagine this and how flabbergasted his colleagues must have been. They probably were thinking: ‘Sumner’s having a mid-life crisis’.

Oh, great, let’s have central banks have to incorporate yet another unobservable into their policy making. That sounds like a really good idea. Although, I guess you think that they are already omniscient enough to target NGDP without doing anything in particular, so I guess adding a whole bunch of unobservables doesn’t matter.

“Have you ever heard of the prediction market?”

Obviously. Regardless, (assuming a prediction market is a proxy for the rationally expected value of something in a DSGE, which is almost definitely not true) suggesting we target the prediction market still doesn’t explain what monetary policy actually does. Are you suggesting that central banks adjust the monetary base mechanically as the prediction market goes off target? Or interest rates? Until someone actually specifies a monetary policy rule, all that’s being suggested is that the central bank set the prediction market on target by setting the prediction market on target. This is basically the same thing as setting the variable as exogenous and, as such, doesn’t do anything to address my criticism.

“The Bank of Japan adopted negative interest rates for the first time at the end of its two-day policy review on Friday, buckling under pressure to ease concerns about the health of the world’s third-largest economy.

In a move that was signaled by the Nikkei business daily minutes ahead of the decision, the BOJ said it will apply a rate of negative 0.1 percent to excess reserves that financial institutional place at the bank and introduce a three-tier system on rates .

The news saw the benchmark Nikkei shoot up 3 percent, the yen slide 2 percent against the greenback and U.S. stock futures rally 1 percent.”

@Ben Cole: The BOJ is still leaving IOER positive in the move on the existing base. That really makes it a much weaker move than the headline. The close vote and recent flip-flopping on negative rates further weakens the message to markets that Japan is doing everything it can to get back to 2%.

The Fed announced its bank stress test criteria. This year they are stress testing a NEGATIVE NGDP scenario. They used to stress test against oil price spikes, rapid interest rate rises, and a housing crash.

“For the 2016 cycle, the severely adverse scenario is characterized by a severe global recession in which the U.S. unemployment rate rises five percentage points to 10 percent, accompanied by a heightened period of corporate financial stress and negative yields for short-term U.S. Treasury securities. The adverse scenario features a moderate recession and mild deflation in the United States, as well as weakening economic activity across all countries included in the scenario”

I’m no expert on Lehman either but if the Fed, on its own decision, was to try to save a very highly leveraged investment bank by changing policy that affects everyone in order to save that one particular investment bank, then I would have a problem with it. Maybe I’ve misunderstood, but advocating a NGDP level target for the Fed does not mean that a bank will never fail due to poor risk assessment and bad decisions does it? My point being that you don’t have to argue that NGDPLT protects individuals, or corporations, from their own mistakes.

Seems B. Cole’s post on the JP central bank negative rates and the recent (Scandinavian, Korean, US) studies to abolish paper money (I have a thread at Kitco’s Gold Forum on this), which is in monetary theory inflationary since banks can offer negative interest rates on electronic balances, is further evidence that MMs will attempt to play with money to get out of the current funk. It will come to naught but Sumner will have a field day explaining why it didn’t work (a few years from now).

Somewhat related:
Here is the Bank of Japan’s statement on its decision to adopt negative interest rates (minus 10 basis points).https://www.boj.or.jp/en/announcements/release_2016/k160129b.pdf
It seems like global real interest rates have fallen even further over the last 1-2 years. In that regard, the decision by the Fed looks increasingly foolish. They are trying to swim against the stream, but won’t succeed. The Wicksellian interest rate in the US seems to have fallen as well – or at least we can be pretty confident that it didn’t rise.
There is thus a pretty good chance that the US rate hike will be one of those cases of premature tightening. And we thought they had learned from the Swedish experience, the experience of the ECB, etc., etc. I guess that the chance of a US recession is still significantly below 50%, but it becomes increasingly more likely. Of course, everything depends on the future course of monetary policy. Anybody’s guess what they will do in March or later on this year. I think the biggest problem right now is that nobody really knows, the Fed’s reaction function is getting more and more obscure. Bad news.

“This is a completely meaningless distinction, when it comes to monetary policy. As Nick Rowe points out there is no meaningful distinction between the Fed acting and not acting.”

That is totally false. Only if you make the ridiculous assumption that the Fed is causing me to spend $500 out of my paycheck instead of spending $1000 out of my paycheck, does it follow that the Fed is causing ALL outcomes of spending.

Obviously there is a “meaningful” distinction between Fed activity and Fed inactivity. That distinction is made by reference to a free market. This is the case even if there is no free market in money. You and Rowe may not like hearing that, but it is absolutely the case, just like it is the case that there is a meaningful distinction between slavery and not slavery in a world of total slavery, and between racism and not racism in a word!d full of racism, and between communism and capitalism in a fully communist (or capitalist) world.

Just because the Fed holds a monopoly over the issuance of money, that does not imply they control the price of hamburgers. But according to your and Rowe’s logic, they are. They are controlling the price of hamburgers even when they do not directly target the price of hamburgers, in exactly the same way you claim that the Fed controls NGDP even though they do not directly target the price of hamburgers.

What is going on here is that you are so far over your head in having faith in socialist money, that you see the Fed everywhere you look, to the point of attributing to the Fed all monetary outcomes. That is massively confused.

When you read people say that market monetarists are not able to understand the difference between something happening that the Fed did not prevent, and the Fed directly causing that event to occur, it is not argument to deny this distinction by assuming that the Fed COULD have controlled that variable if they really wanted. Yes, the Fed COULD have controlled the price of hamburgers if they wanted, or oil, or cars, or tuition, or a zillion other things, but they did not. Therefore, the cause of these price trends is not ONLY the Fed. There are other people that are having a causal effect here.

The failure to perceive non-Fed causes for monetary events is not a result of observation, but a bad theory.

If the Fed only is always controlling NGDP even when they do not target it, that is another way of saying the market never has any effect on NGDP.

Well, by that logic, if the Fed ceased targeting interest rates and price levels, then the Fed only would still be in control of them. You know, “meaningless distinction” and all that.

So where the hell is the “market” in market monetarism again? It is a contradiction to claim “let the market set interest rates and prices”. Um, no, you just told us the Fed controls monetary variables even when they do not intentionally target them.

E. Harding, Far more were closed after the Bank Holiday (even as NGDP soared) than before the holiday. That’s hard to the “finance crisis is the key” people to explain.

Agree on unemployment in the subprime states–notice that unemployment in Texas has recently edged up to 4.6%. But the national rate has not.

John, You said:

“The monetary base and interest rates are natural indicators of monetary policy; central banks have the direct ability to set the monetary base or set interest rates (leaving MB demand determined). Strangely, you also have no problem adding “M2 … and NGDP expectations” — both things that no central bank has direct control over — to your list of monetary policy ‘tools.’ Additionally, you refer to exchange rates as a tool of policy instead of a goal of policy.”

The Fed doesn’t directly control interest rates, it targets them by adjusting the base (or IOR). But that’s a choice. Friedman favored targeting M2. The Singapore central bank targets exchange rates, as did most central banks under Bretton Woods. I favor targeting the price of NGDP futures contracts. These are all possible policy option. In each case the base is the instrument of policy.

Also, don’t confuse policy targets with indicators, I was talking about indicators. Bernanke agrees with me, so there is nothing strange about my claim.

The rest of your post completely mischaracterizes my claim. Hard to believe you are serious. I’ve never suggested they could peg the actual inflation rates, that’s nonsense, as you suggest. I’m surprised to see you are still so uninformed about my actual policy views. I suggest you reread some of my older posts. Lars Svensson talks about talking the forecast, and he’s a very respectable NK, frequently praised by Krugman. Is he also a crackpot in your view?

Your final comments on liquidity traps have no bearing on this post, as the US wasn’t in a liquidity trap in 2008, indeed the Fed was worried about high inflation, even after Lehman failed in September. That’s why they didn’t cut rates. And you might want to check the market response to the BOJ’s move today, it drives one more stake into your liquidity trap worldview. Facts are stubborn things.

@Christian List: the collapse of housing was a bubble that produced a real shock. It has nothing to do with money neutrality. Put another way: if the Fed doubled the money supply by mandating that hereinafter every $1 will be nominally $2 (by law), overnight prices should double but it will have very little real affect on the economy. By contrast, a real shock (like a meteor destroying NYC and/or half the Eastern seaboard), a stock market bubble bursting, or housing prices crashing due to over-investment in the housing sector) could produce a recession (could not would, since it’s been said even severe natural disasters rarely cause a recession).

It’s a distinction that I think Sumner does not get, so if you don’t get it I won’t be surprised. The key is mal-investment in a particular sector of the economy, rather than the overall price level of the economy.

The banks generally fell in leverage order, not according to the composition of their balance sheets. E.g. Bear fell not becaus it had more sub prime than others, it fell because its leverage ratio was 36:1 (as high as 42:1 except when the books were scrubbed with repo transactions).

You don’t need to know what the bank was holding in its assets to know if it failed in the crisis. You just need to know its leverage ratio. That points to an aggregate such as ngdp growth as the crux.

Could someone explain why Krugman says “if there were anything to this story, we should have seen a sharp increase in long-term real interest rates, as investors saw the Fed getting behind the disinflationary curve”? I would expect to see inflation breakevens dropping if there was tightening, but I’m not sure why real rates would spike. You do see inflation breakevens collapse, but a bit later than Beckworth and Ponnuru imply. They say the Fed started tightening in April, but you don’t really see inflation breakevens move much until September, by which time it was more likely a response to the intensifying financial crisis rather than the Fed’s monetary policy.

So the Government takes over the production of currency, and then the monetary system.
Under the old free banking system when people hold more currency the banks print more.
Also because people have more trust in Gov. than in banks they tend to hold more currency when they are frightened.
Then Government fails to print enough money when people hold more but it is not their fault?

Your honor, while the prosecution claims I caused the accident by driving into a wall, this is an incorrect interpretation of what the word “caused” means. In fact, I just failed to avoid the accident by not turning when the road turned.

Jerry Brown
“I’m no expert on Lehman either but if the Fed, on its own decision, was to try to save a very highly leveraged investment bank by changing policy that affects everyone in order to save that one particular investment bank, then I would have a problem with it.”

Actually, what was shocking at the time was that the Fed didn’t try to save Lehman. Bernanke said that as Lehman was not a bank, it was beyond his power to do anything about it. Actually, he did try to negotiate the sale of Lehman before bankruptcy, but couldn’t get a deal together.

Despite the popular opinion that Lehman was the cause of the crisis, I firmly believe that Lehman was a consequence of the crisis. The Fannie Mae implosion one week earlier was a much bigger deal in my mind.

Does anyone else find Jeb’s economic “record” hilarious when everyone know it was 100% related to the Housing Bubble? So in FL and Vegas and ATL metro wouldn’t one be able to find a strong correlation between the housing bust and unemployment?

“Civilian Labor Force is the sum of civilian employment and civilian unemployment. These individuals are civilians (not members of the Armed Services) who are age 16 years or older, and are not in institutions such as prisons, mental hospitals, or nursing homes.”

“Put another way: if the Fed doubled the money supply by mandating that hereinafter every $1 will be nominally $2 (by law), overnight prices should double but it will have very little real effect on the economy.”

I think it’s better to work with real examples. Why is it a shock when asset prices suddenly decline by $7 Trillion USD? Or if you really want a thought experiment: What will happen if the FED could and would cut the money supply in half overnight? What would happen? Think of a worker who earns 3000 $ a month. How does he react? Would he say: “I’ll take a cut by 1500 $”?! I think he won’t. Humans don’t think this way.

“the collapse of housing was a bubble that produced a real shock.”

Yes, it was a real shock. But do you explain why? You seem to think in abstract terms and concepts like “bubble”. But what do these concepts even mean? Do they have a real meaning? I don’t see their meaning.

@Christian List – we could be in violent agreement, talking past each other. Or we could disagree on fundamentals. Or we could both be wrong. I believe the economy is non-linear and anything can happen. I disagree with ‘one-variable’ nostrums. Herd behavior matters. Likely the housing bubble of 2006 was a shock that caused panic due to the financial sector being affected; but due to human nature the S&L crisis of the 1980s did not cause recession. Likewise I’ve read once that the Crash of 1929 was a routine recession than turned into a Great Depression / GD(due to ‘policy mistakes’ it is said, but I disagree, I think it was just chance). I would argue, unlike Sumner, that it was just herd behavior not the strong gold dollar that was at work in causing the GD. (As an aside, I read a book review of Sumner’s latest book and am pleased to find he agrees, as I always did, that the Great Depression more or less lasted until FDR got into power, about 4 years, not the conventional wisdom of over ten years) As for sticky wages, I don’t think they exist outside of unions. Back in the says of the 1950s, union membership in the USA peaked, but it’s at record lows now. Same worldwide. Unfortunately this is not the time or place to discuss this, due to WordPress limitations. My email is raylopez 88 at gmail dot com.

“The Fed doesn’t directly control interest rates, it targets them by adjusting the base (or IOR). But that’s a choice. Friedman favored targeting M2. The Singapore central bank targets exchange rates, as did most central banks under Bretton Woods. I favor targeting the price of NGDP futures contracts. These are all possible policy option. In each case the base is the instrument of policy.”

Regardless, my point still stands: you judge monetary policy based on objectives instead of instruments. If the monetary base is constant and NGDP falls, then the central bank is still doing nothing. At least the Fed Funds rate is directly linked to the monetary base, though. With everything else, the connection is not nearly as direct, and as such nothing that you listed originally besides the monetary base and the fed funds rate should be used to evaluate the actions of the central bank; regardless of what Bernanke or anyone else thinks.

“I’ve never suggested they could peg the actual inflation rates, that’s nonsense, as you suggest.”

I’m suggesting that what you do is similar enough to be worthy of the same criticism; you simply assume that central banks can control whatever nominal variable you feel like they should at the moment and reason from that. If the Fed could have kept NGDP growing at 5% in 2009, there would not have been a recession, but no one should care — the only relevant question to ask is if the Fed could control NGDP in 2009 and, considering the fed funds rate fell to zero in 2009 and NGDP still fell, this was evidently not the case. You try and rescue yourself by claiming that the Fed’s failure to cut interest rate in the previous year cause the natural rate to fall below zero, but this doesn’t make any sense.

First of all, every single model I’ve ever seen would have changes in the natural rate consistent with changes in potential GDP — by definition not controlled by any central bank. If you have a different position, which you apparently do, please derive the result from a model instead of just asserting it. Somehow, you seem to think that the current natural rate of interest is somehow related to the gap between last period’s natural rate and the current interest rate. Do you have any reasoning for this history dependence, or did you just decide that current monetary policy affects future natural rates because it’s a convenient position to have? Conventional analysis suggests that, if the natural rate was negative in 2009 (which is obviously was), there is nothing that the Fed could have done to prevent a recession.

“Lars Svensson talks about talking the forecast, and he’s a very respectable NK, frequently praised by Krugman. Is he also a crackpot in your view?”

To my understanding, there’s a distinct difference between what you are suggesting when you call for central banks to target the forecast and what Svensson is suggesting: he actually thinks that central banks need to do something with nominal interest rates to get there, you don’t care about the how and just suggest that central banks target the forecast by targeting the forecast. Implementation is really important: Svensson suggests that central bank lower the nominal interest rate when they expect inflation to be below target (and vice versa) while you suggest that central banks refuse to allow off-target forecasts in equilibrium. You’re suggestion only works in models where you can set any odd variable as exogenous and see what happens, his suggestions are actually relevant to the real world.

“Your final comments on liquidity traps have no bearing on this post, as the US wasn’t in a liquidity trap in 2008”

Actually, Konczal brought up the liquidity trap that followed (the natural rate falling below zero) and you responded:

“Is the argument that we’d somehow avoid the zero-lower bound? Ben Bernanke recently showed that interest rates would have had to go to about -4 percent to offset the Great Recession at the time. Hitting the zero-lower bound earlier than later is good policy, but it’s still there.

There are lots of problems here. The Bernanke claim was that the Taylor rule implied a minus 4%, but that’s in 2009, not 2008. And that distinction really matters! The graph Konczal shows has the Taylor Rule suggesting an interest rate in positive territory in 2008. In any case, the Bernanke article Konczal links to is critical of the Taylor Rule, so it cannot possibly be used as evidence that Bernanke thought a negative 4% interest rate was appropriate in 2008, or even 2009. If he had thought that, why would the Fed have set rates at positive 2% in mid-2008? Sure, there are data lags but not 600 basis points worth of them. The fact of the matter is that the Fed didn’t cut rates more aggressively because at the time they thought it would lead to excessive inflation. It’s pretty hard to now claim that our wonderful economic models somehow show that even far lower interest rates could not possibly have prevented deflation and deep recession in 2009. If our models were that accurate we never would have had a Great Recession.”

Effectively, a negative natural rate in 2009 was inevitable (regardless of your completely unfounded idea that current monetary policy effects future natural rates), so the interest rates in 2008 were completely irrelevant for the great recession. Furthermore, continuing without your strange model of the natural rate of interest, Konczal argues that looser money in 2008 would not have made unemployment much lower in 2009. You respond by questioning the conventional view that NGDP fell out of control of the Fed: “So is Konczal claiming that the Fed would have been unable to boost NGDP? Why?”

My liquidity trap arguments were completely justified.

I think it all comes down to this: I think monetary policy effectiveness is a result that always needs to be derived, you think it’s fair to simply assume it. Your assumption is fair most of the time, but it can still be dangerous, in my opinion.

The issue with the natural rate is different though: as far as I can tell, you just made up the idea that tight money causes the next period’s natural rate to fall because it makes your argument that the Fed could have prevented the great recession viable. Otherwise, everyone else it right and the negative natural rate in 2009 was inevitable, so the Fed was not complicit in high unemployment.

Of course, I’m open to a reasonable explanation of how exactly tight money results in lower natural interest rates from a theoretical perspective, as long as you have one to supply.

Tom, I don’t like the term ‘model’ in that graph, it could cover a multitude of sins.

John, You said:

“Regardless, my point still stands: you judge monetary policy based on objectives instead of instruments. If the monetary base is constant and NGDP falls, then the central bank is still doing nothing.”

Whoa!, Now you’ve completely switched your argument. So are you saying the Fed adopted a really tight money policy in late 2007 and early 2008 when base growth came to a screeching halt? And did that cause the recession? The base is now your monetary indicator?

There’s no difference is saying the Fed doesn’t directly control the Fed funds rate and saying they don’t directly control NGDP growth expectations.

You said:

“I’m suggesting that what you do is similar enough to be worthy of the same criticism; you simply assume that central banks can control whatever nominal variable you feel like they should at the moment and reason from that.”

Still completely wrong. “Whatever nominal variable?” Seriously? Didn’t I just tell you I didn’t think they could peg the inflation rate? Inflation is a nominal variable. You need to take a deep breath and think a bit more before you type long responses–and don’t assume I am dumb–every argument you provide I’ve seen many times before.

You said:

“but no one should care — the only relevant question to ask is if the Fed could control NGDP in 2009 and, considering the fed funds rate fell to zero in 2009 and NGDP still fell”

Still fell? Don’t you see that you’ve reversed causation? Interest rates fell because NGDP fell. I strongly suggest reading Friedman and Schwartz’s book on the Great Depression—this is nothing new.

You said:

“First of all, every single model I’ve ever seen would have changes in the natural rate consistent with changes in potential GDP”

The natural rate is strongly procyclical, and model that doesn’t say so is missing an important part of reality. Look at a recent paper by Curdia (a respected NK), which has the natural rate plunging in late 2008—was that a fall in “potential output” that just happened to occur when the economy crashed.

You said:

“To my understanding, there’s a distinct difference between what you are suggesting when you call for central banks to target the forecast and what Svensson is suggesting: he actually thinks that central banks need to do something with nominal interest rates to get there, you don’t care about the how and just suggest that central banks target the forecast by targeting the forecast.”

That’s just wrong. Two policies that both target the forecast for inflation will involve identical paths of interest rates, even if only one actually targets the interest rate. So I ask the question again, is Svensson also crazy?

You still aren’t getting it. Svensson is saying that the rate should be lowered if not lowering it would lead to off target inflation. I agree. He wants the rate set at a point where the inflation forecast is on target. It’s the difference between conditional and unconditional expectations.

You said:

“Effectively, a negative natural rate in 2009 was inevitable ”

Seriously, that’s just crazy. We adopt a Zimbabwe style hyperinflation policy and still get a zero NOMINAL natural rate? That’s nuts. Nothing nominal is inevitable.

You said:

“The issue with the natural rate is different though: as far as I can tell, you just made up the idea that tight money causes the next period’s natural rate to fall because it makes your argument that the Fed could have prevented the great recession viable. Otherwise, everyone else it right and the negative natural rate in 2009 was inevitable, so the Fed was not complicit in high unemployment.”

Please don’t assume that others agree with you. I’m pretty confident Ben Bernanke would tell you that the eurozone natural rate is now lower than the US natural rate precisely because the ECB foolishly tightened policy in 2011 and the Fed id not. Yellen would probably agree. Please don’t assume that your views of macro are widely held. Even Krugman thinks that BOJ monetary stimulus has been effective at the zero bound, and he’s about as Keynesian as there is. Your views are the extremist views. That’s fine, I have no problem with that–but don’t assume they are the conventional view.

“Whoa!, Now you’ve completely switched your argument. So are you saying the Fed adopted a really tight money policy in late 2007 and early 2008 when base growth came to a screeching halt? And did that cause the recession? The base is now your monetary indicator?”

No, I’m not suggesting we use the monetary base as an indicator for the “stance of monetary policy,” I’m suggesting it should be the indicator of whether or not a central bank is doing something. A constant monetary base may be “tight” monetary policy or “loose” monetary policy in an abstract sense — since neither term really means anything. You’ve defined tight monetary policy to be whenever NGDP falls, I think this is like you defining “tight money” as “whenever a recession happens.” I guess you can hold this view, but I still think you need to derive the result that the central bank always causes NGDP to fall when it does before you conclude that every recession is caused by the central bank.

“Still completely wrong. “Whatever nominal variable?” Seriously? Didn’t I just tell you I didn’t think they could peg the inflation rate? Inflation is a nominal variable. You need to take a deep breath and think a bit more before you type long responses–and don’t assume I am dumb–every argument you provide I’ve seen many times before.”

I agree that you said you agree that inflation pegs are ridiculous, but I don’t agree that your methodology is really all that far off from that. You can say you don’t do something all you want, but that doesn’t necessarily make it true. You evidently don’t care about modeling monetary policy to the extent that central bank omnipotence is a result instead of an assumption.

“So I ask the question again, is Svensson also crazy?”

No. He talks about how central banks achieve their objectives, you don’t.

“Seriously, that’s just crazy. We adopt a Zimbabwe style hyperinflation policy and still get a zero NOMINAL natural rate? That’s nuts. Nothing nominal is inevitable.”

You are assuming that we could or would have caused enough inflation expectations in 2008 for the natural rate in 2009 to have been positive. If the natural rate was, for instance, -4% as Bernanke’s modified Taylor Rule suggested, then expected inflation would have had to be about 4% higher in 2008. Do you honestly think that the Fed, even if they were targeting NGDP, would have done this before it hit the zero lower bound? Not only would that mean inflation much higher than target, but also NGDP growth above your target of 5%. I don’t deny that a much larger monetary base in 2008 (assuming the increase was permanent) would have been able to raise NGDP (as opposed to in 2009, when it didn’t do much of anything), but the required monetary expansion to prevent the Great Recession would certainly be much bigger than any inflation targeting central bank would want. Even an NGDP targeting central bank would have refused to raise inflation expectations (while it still could without open mouth operations) to the extent required to accommodate the financial crisis shock. Besides, an increase in inflation expectations of this degree would have required a higher nominal interest rate in 2008, which the Fed would have never done even if it was caused by large increases in the monetary base (resulting in lots of expected inflation) instead of a reduction in the monetary base.

“Please don’t assume that others agree with you. I’m pretty confident Ben Bernanke would tell you that the eurozone natural rate is now lower than the US natural rate precisely because the ECB foolishly tightened policy in 2011 and the Fed [d]id not. Yellen would probably agree. Please don’t assume that your views of macro are widely held. Even Krugman thinks that BOJ monetary stimulus has been effective at the zero bound, and he’s about as Keynesian as there is. Your views are the extremist views. That’s fine, I have no problem with that–but don’t assume they are the conventional view.”

As usual, you just appeal to what [insert ostensibly respected individual who I think this guy will side with] thinks to try to sway me instead of actually making an argument. Nowhere in any NK model does the natural rate rate of interest depend on past monetary policy and this reality would only fail to extend to the natural nominal interest rate if expected inflation somehow depended on past monetary policy. Do you have a (preferably microfounded) model that exhibits the behavior you suggest, or are you simply content to keep appealing to authority?

Maybe agents are backward looking, so expected inflation does depend on last period’s interest rate and output gap, but I doubt you’d like that explanation given your support of EMH and the fact that you call yourself a market monetarist.

Otherwise, perhaps interest rates that are too high cause the expected growth rate of potential GDP to fall. I don’t have a clue why the would make any sense, though.

Alternatively, high interest rates cause the equilibrium capital to labor ratio to increase — yet again, I don’t see this making any sense.

“There’s no difference is saying the Fed doesn’t directly control the Fed funds rate and saying they don’t directly control NGDP growth expectations.”

There’s a huge difference between the two. The Fed controls the Fed Funds rate by directly intervening the the Fed Funds market.

No such thing exists for NGDP though, arguing that the Fed controls NGDP expectations does not imply a mechanism. You can only reasonably make the claim that the Fed can peg something leaving the MB demand determined is when the Fed is pegging the price of a variable it has monopoly control over. As an approximation to the opportunity cost of holding money, the nominal interest rate can be seen as the price, which the central bank sets and will supply whatever quantity of money is demanded at said price.

“AD plunged due to a tight money policy from April 2008 to October 2009, which caused unemployment to soar from 5% to 10%.”

That is flat out wrong. The fall in AD was caused by the soaring unemployment and decline in spending on capital goods. AD logically and temporally follows wage payments, it does not preclude them.

Nominal demand for capital goods and consumer goods, which is what NGDP measures, is not demand for labor. NGDP is in competition with wages. All else equal, a rise in one requires a fall in the other.

[…] Scott Sumner writes that the financial crisis as a whole would have been far milder if the Fed had kept NGDP growing at roughly 5%/year. And the reason is simple; at that growth rate the asset markets would have been far stronger, and the crash in asset prices severely impacted the balance sheets of many banks, including Lehman. Keep in mind that the subprime crash was not big enough to bring down the banking system. Rather when NGDP growth expectations plunged, the prices of homes in the (non-bubble) heartland states, as well as commercial property, began falling. This is what turned a manageable financial crisis into a major crisis. […]

“I think this is like you defining “tight money” as “whenever a recession happens.””

Oh really? Did you check out NGDP growth in Zimbabwe in 2008, when they were in recession? Yes, in the US NGDP is strongly correlated with recessions, far more strongly than inflation. So which variable should we target? NGDP, obviously.

As far as “doing something”, is a Fed change in IOR or reserve requirements doing anything? After all, the base doesn’t change. Is that your argument? Almost everyone believes those policies represent the Fed doing something in a concrete action sense.

Then you have a long paragraph insisting that my beliefs imply the Fed can peg the price level, without providing any evidence. I’ve said they can peg CPI expectations, or NGDP expectations, but that’s a very different claim. The actual CPI is never going to be precisely controllable.

You said:

“No. He talks about how central banks achieve their objectives, you don’t.”

Actually I provide more concrete actions than he does. Svensson gives one answer, set monetary policy where the central bank’s internal model says the goal variable is on target. I say that is one option, or the central bank can target NGDP futures prices. Thus I give two options where Svensson only gives one. So again, you are missing the point somehow.

You said:

“If the natural rate was, for instance, -4% as Bernanke’s modified Taylor Rule suggested, then expected inflation would have had to be about 4% higher in 2008.”

No expected inflation would not have had to have been 4% higher, NGDP growth would have had to have been about 4% higher, in other words at least 1% instead of minus 3%. Your mistake is to forget that SRAS curves are upward sloping, and that both faster RGDP growth and faster inflation impact the nominal natural rate. Always talk in terms of NGDP growth, and forget about inflation–it doesn’t matter. In a counterfactual where NGDP growth was 4% higher, it’s quite likely that both RGDP growth and inflation would have been higher, indeed you implied as much with your claim that falling NGDP is identical to recessions.

You said:

“Not only would that mean inflation much higher than target, but also NGDP growth above your target of 5%.”

Nope, even 1% NGDP growth from mid-2008 to mid-2009 would have been 4% higher than actual growth. Obviously NGDP growth of 5% would have been even better, but in my view a compromise figure of around 3% or 4% would have been fine, and would have led to less inflation–if that’s your concern.

“I don’t deny that a much larger monetary base in 2008 (assuming the increase was permanent) would have been able to raise NGDP”

Actually, under my proposal there would have been a much smaller monetary base (as in Australia), as we would not have hit the zero bound. Expectations fairies are the most powerful tool.

The Fed has a dual mandate, equal weight on inflation and jobs. So some extra inflation and modestly higher unemployment would have been the proper tradeoff in 2009, consistent with the dual mandate. Instead we had the worst of both worlds, deflation and soaring unemployment—that makes no sense.

You said:

“Nowhere in any NK model does the natural rate rate of interest depend on past monetary policy and this reality would only fail to extend to the natural nominal interest rate if expected inflation somehow depended on past monetary policy.”

Models abstract from reality. Thus simple Keynesian cross models used to leave out the investment accelerator, which was an obvious real world complication. Look, if tight money causes a depression then the natural rate obviously falls, surely you can see that? Any model that does not include that fact is obviously leaving out something important. Robert King has a model published in the 1980s explaining that easy money can raise interest rates (both real and nominal) in a rational expectations model. How can that occur unless easy money is raising the natural rate? So I’m quite sure that such models exist, I just don’t have the recent one’s at my fingertips. But again, just think logically—how could the natural rate not be lower in a deep depression? What is the demand for credit if firms are producing at 50% of capacity? There’s going to be an obvious shift left in the investment schedule, which lowers the natural rate. You should leave comments over at Nick Rowe’s blog, he could explain the theoretical explanation in terms of NK models better than I can. I am out of date.

John, You said:

“There’s a huge difference between the two. The Fed controls the Fed Funds rate by directly intervening the the Fed Funds market.”

That’s missing the point. Suppose I said the Fed targeted 3 month T-bill yields. They used to do this back in the late 1940s. And they can do so without directly intervening in the T-bill market, because base injections will affect T-bill yields regardless of whether you are buying T-bills or some other asset. The Fed can target forex rates or gold prices or any other variable, without directly intervening in those markets. It merely needs to adjust the base up or down until the target variable is on target. If the policy is credible, the market price won’t stray far, as the market participants know the Fed will soon nudge it back on target.

Second, the Fed can create a NGDP futures market.

Third, if they don’t have one, they can use the Svensson procedure, and develop a model of the relationship between the base and NGDP growth, and then set the base where the model predicts NGDP growth will be on target.

Tom, Sorry, but you are wasting your time linking to his blog. I’ve looked at it and have no interest. And he’s pretty arrogant for someone who is self taught in economics, and seems incapable of writing in a style accessible to other economists. What are we supposed to think? Nobody wants to read a blog written in a private language.

[…] Scott Sumner writes that the financial crisis as a whole would have been far milder if the Fed had kept NGDP growing at roughly 5%/year. And the reason is simple; at that growth rate the asset markets would have been far stronger, and the crash in asset prices severely impacted the balance sheets of many banks, including Lehman. Keep in mind that the subprime crash was not big enough to bring down the banking system. Rather when NGDP growth expectations plunged, the prices of homes in the (non-bubble) heartland states, as well as commercial property, began falling. This is what turned a manageable financial crisis into a major crisis. […]

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.